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Beyond the Banks: What Derivative Regulation means for the corporate world

PwC

Regulatory reform through Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) and Basel III is about transparency, making the derivatives world less opaque, and more standardization. While the end goal of the derivatives provisions is less risk and greater stability in the market, these new standards come at a potentially considerable cost for all derivatives users—not just dealers and financial services companies.

Corporate End Users will pay more for over-the-counter (“OTC”) derivatives as banks pass along the increased cost of their own compliance to customers. Beyond the actual costs of the derivatives themselves, corporates will also incur the costs to comply with certain elements of the new trading regulations—including the increased recordkeeping and reporting requirements.

The majority of non-financial services companies using OTC derivatives to hedge and mitigate commercial risks are likely to be defined by the Act as End Users. End Users may be able to bypass some complexities of the Act by applying for exemptions, notably from trading on an exchange and using a clearinghouse so they can continue to trade OTC derivatives. Still, they’ll be impacted by increased costs and margin requirements, and they’ll have to meet the recordkeeping, reporting and business conduct rules applicable to all users, plus annually file their End User election with the regulators.

Navigating the End User pros and cons

When compared to exchange-traded futures, key benefits of OTC derivatives include easier customization to risk and lower collateral and daily margin requirements. But soon, if a company does not qualify for or elect the End User exemption, the Act requires swaps to be traded on an exchange and cleared through a central clearinghouse.

By forcing a portion of swap transactions into these regulated clearing institutions, the Act concentrates risks into one location and ensures both parties honor their trade obligations. Regulators will monitor the exchanges and clearinghouses for increased standardization, greater transparency, and collateral requirements.

Corporates eligible for the End User exemption must decide: Should we move to exchanges and/or centrally cleared trades to save on some of the increased costs of using derivatives, or should we continue to trade bilaterally to better manage risk while paying more for derivative positions? In either case, companies will likely post more collateral than before. Centrally cleared derivatives will need daily postings, while counterparties to bilateral trades will also ask for more collateral to help offset their increased costs.

The scope of swap regulation for corporates

In July 2012, the Commodity Futures Trading Commission and the Securities and Exchange Commission released final definitions of “swaps,” a.k.a. contracts that fall under the scope of the Act. This clarified which derivatives were impacted by the Act and which types were excluded from certain requirements. For instance, deliverable forward contracts (which deliver/exchange the underlying currencies rather than net settling) may be excluded from the scope. But non-deliverable forwards (when settlements are combined into one net payment between the company and bank) are included, as well as foreign currency options.

This implies that companies that use only plain-vanilla, deliverable-forward foreign currency derivatives could be spared from the new rules. But they won’t be entirely off the hook: They’ll likely still be hit with higher bid-and-ask spreads, greater transaction costs, and increased requests for higher collateral postings due to Basel III and the other regulatory requirements impacting the banks. And corporates will still be subject to new recordkeeping and reporting requirements—including reporting requirements for inter-affiliate swaps.

Where reform will hit hardest

Business strategy: The increased cost of OTC derivatives will lead companies to alternatives to manage their risk, including exchange-traded derivatives or more strategic OTC use. Not all derivatives will cost the same or have the same hedging power as they did before.

Funding: Financial institutions are expected to pass along increased costs to corporate hedgers, and companies will be asked to post more collateral. Companies must look at their debt and working capital profiles to consider how much collateral they’ll need and have the ability to post, especially as markets shift.

Operations: Processes must be updated to accommodate new types of derivative transactions. Additionally, IT will need to update systems to accommodate complex recordkeeping requirements. Finance managers must ensure that margin and collateral are posted daily.

Accounting: It may become more difficult to obtain and maintain hedge accounting, which could result in increased earnings volatility.

Increased prevalence of margin and collateral

Before the Act, OTC swaps typically required little or no collateral. If positions became too large, then banks sometimes required credit support annexes (CSAs), which are legal documents that regulate collateral for derivative transactions. Now, CSAs or other similar credit support agreements are likely required for all OTC derivative trades, and they’ll require more collateral posting. Previous regulations had less stringent capital requirements. Companies will be forced to manage cash and other liquid, highly rated investments more proactively.

Recordkeeping requirements

All swap counterparties, including End Users, will be required to maintain a full set of data related to each of their derivative positions. These rules apply to all derivatives with expiration dates after July 21, 2010. And it’s not just active swaps that need to be recorded; all swap records must be maintained for five years after the transactions are terminated, and two years’ worth must be readily accessible.

With this much data needed, companies might want to invest in new software. While spreadsheets can manage large volumes of information, companies that deal with a sizeable derivatives portfolio should consider a more practical approach that runs less risk of data entry mistakes or formula errors. Finance, compliance, and IT leaders can work together to design these new systems.

Reporting responsibilities

For every swap, information must be submitted to a swap data repository (“SDR”). SDRs are newly created central locations for data reporting and recordkeeping to reduce risk through transparency. Some of this information will be publicly published in real-time to lend the market more transparency on timing, prices, and volumes of transactions, without revealing party identities. Otherwise, regulators will track derivative activity through confidential reporting.

For a corporate trading with a financial institution, the reporting requirements will likely be the financial counterparty’s responsibility. Corporates doing internal swaps (i.e., interaffiliate swaps) will be responsible for real-time reporting for those trades.

To simplify the reporting complexities, the International Swaps and Derivatives Association (“ISDA”) released a Dodd-Frank Documentation Initiative with a standardized protocol. The ISDA Dodd-Frank protocol lets corporate End Users submit required information in a set format to their counterparties just once, instead of separately to each. The protocol also updates existing trading documentation to decrease trading disruptions and negotiations.

End User path forward

Identify what’s regulated in your portfolio: Assess which instruments meet the official definition of a “swap” or “security-based swap” and thus fall under the scope of the Act.

Evaluate your classification: Establish whether or not the entity that executes the swaps qualifies as an End User, or whether it’s considered a swap dealer (“SD”) or major swap participant (“MSP”). While most corporates won’t be considered SDs or MSPs, heavy users of derivatives, like companies involved in energy or commodities, may.

Weigh the costs and benefits of changing strategies: End Users have numerous choices for executing and clearing their swap transactions, each of which could impact price and cost.

Understand new collateral demands: Consider what impact the increasing collateral requirements will have on liquidity and borrowing. Armed with that analysis, a corporate End User can decide whether to trade on exchanges, trade over-the- counter, continue to trade OTC, or forgo derivatives altogether.

Analyze the administrative and operational requirements: Most derivatives will be subject to new recordkeeping and reporting requirements, so new systems for mass data storage and other compliance matters will need to be in place. Companies should look into outsourcing some of the necessary tools and infrastructure as well as exploring processes and liquidity requirements for posting collateral.

Assess impact on financial accounting and reporting: Standardized derivatives may not exactly match the terms of the hedged exposure, leading to a requirement to apply the more complex hedge accounting requirements (i.e., application of long-haul hedge accounting) as well as income statement volatility.

So while some rules are not final, it’s clear that the Act will have a significant effect on most corporates. Companies must start planning now so they’re not caught off-guard by growing costs, demands on cash, and changes in risk management.

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